Like Dwarves in a Barrel: Stocks Rocked as Fed Meeting Approaches

In Peter Jackson’s the Desolation of Smaug, the second part of his Hobbit trilogy, Bilbo Baggins and his dwarf companions make their escape from a group of elves by hiding inside barrels and being swept down a river. Investors this week can surely sympathize with those dwarves, as the stock market provided a rocky and uncomfortable ride, and stocks like Nike (NKE),  United Health (UNH) and United Technologies (UTX) pulled the major benchmarks down. Unlike last week, this time there was no escape.

Warner Bros. Pictures

The S&P 500 fell 1.65% to 1,775.32 this week, its largest drop since the week ending August 30, while the Dow Jones Industrial Average fell 1.65% to 15755.36, its largest drop since August 16. Shares of United Technologies dropped 3.4% this week after the industrial conglomerate lowered its earnings guidance this week, while Nike declined 4.3% to $76.40 ahead of next week’s earnings. United Health finished the week off 4.1% at $70.48 just because it could.

Which isn’t to say there weren’t some winners. United States Steel (X) gained 3.7% to $27.31 this week on the back of a Cowen upgrade, while Visa (V) rose 2.7% after Mastercard (MA) announced a buyback, dividend increase and stock split.

Why the drop? If I had to hazard a guess, investors used next week’s Fed meeting as an excuse to lock in some of this year’s gains. And there was plenty of Fed news, from the potential nomination of Stanley Fischer as Vice Chairman to economic data that could mean the taper begins sooner rather than later.

Just don’t expect it to occur next week, say RBC Capital Markets’ Tom Porcelli and team. They write:

We remain surprised by how many investors think there is a real shot the Fed tapers next week. They are not in the majority – not by a long shot – but the group seems to have gained a few more constituents of late…

December is a long-shot. We are sympathetic to the idea that the Fed is more than capable of surprising the markets and we will not discount some move by the committee to set expectations about the eventuality of tapering (whether in the statement itself or in Bernanke's press conference). That said we think they will stop short of engaging in tapering at this meeting and our base case remains that asset purchases will be scaled back in March – with January odds increasing, to be sure.

Citigroup’s Tobias Levkovich expects markets to head higher in 2014 but warns investors to expect a bumpier ride. He writes:

Volatility is expected to pick up entering 2014 after a rather smooth ascendant market this past year, but short-term indicators intimate that the environment will be somewhat less calm in coming months. Indeed, even the resumption of taper talk in 1Q14 could be disruptive, not to mention probable earnings estimate reductions during the January/February EPS release period given that consensus bottom-up
numbers are too high.

Don’t expect investors to rush back into stocks even if the Fed does start to taper, says UBS’s Daniel Rudis. He writes:

The recent abundance of money has disguised the ‘true’ interest rate and has made it hard to estimate what the demand for stocks would be in the absence of central bank intervention. Even a great rotation is unlikely to take us back to the equity allocation levels seen in the nineties, since aging demographics in developed markets have curbed risk appetite. Structurally, lower risk tolerance is likely among the reasons for lower equity holdings in pension portfolios…

Morgan Stanley’s Graham Secker tells investors to favor developed-market stocks over emerging-market equities. He writes:

While the outperformance of DM over EM has been quite significant this year, we still think it’s too soon to rotate back into EM for three reasons. From a valuation perspective, EM isn’t quite cheap enough yet on relative price to book or relative ROE, where EM is only slightly below the long-run average relative to DM, and not yet at the washout levels that we look for to make a rotation back to EM.

Maybe we should all just seek a haven inside a barrel instead. Or better yet, a bottle.